monopoly - hsto.infomonopoly & perfect competition perfect competition: every supplier perceives...
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Monopoly
Herbert Stocker
Institute of International StudiesUniversity of Ramkhamhaeng
&Department of EconomicsUniversity of Innsbruck
Monopoly
Definition
A firm is considered a monopoly if . . .
it is the sole seller of its product.
its product does not have closesubstitutes.
Repetition
Remember:
Firms maximize their profits subject to therestrictions they face.There are two kinds of restrictions:
Technological restrictions.Market restrictions.
Repetition
Remember:
Technological restrictions are the same formonopolies and for firms on perfectlycompetitive markets.These are embedded in the cost function:Remember that we did not need the price ofoutput for the derivation of the cost function!
Only market restrictions differ betweenmonopolies and firms on perfectly competitivemarkets.
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Monopoly & Perfect Competition
Perfect Competition: Every supplierperceives demand for his own product asperfectly elastic, he can sell every unit ofoutput for the same price.Therefore, marginal revenue is simply the price,and firms are price-takers!
Monopoly & Perfect Competition
Monopoly: A Monopolist is the only supplierand there are no close substitutes for hisproduct. Therefore he perceives that thedemand for his product is falling when heincreases price.Monopolistic firms are price-seekers; if theywant to sell more, they can do so only at alower price!
This has important implications for themarginal revenue of a monopoly, e.g. marginalrevenue no longer equals price!
Perfect Competition vs. Monopoly
Perfect Competition:
P
Q
‘perceived’Market Demand
Each producer perceives the
demand for his product as
perfectly elastic.
Monopoly:
‘perceived’Market Demand
P
Q
Monopolist perceives demandto be less than perfectlyelastic.
Total and Marginal Revenue
Example:
Q = 6 − P Total Marginal AveragePrice Quantity Revenue Revenue Revenue
P Q R = P × Q MR AR = P
6 0 0 – –5 1 5 5 54 2 8 3 43 3 9 1 32 4 8 −1 21 5 5 −3 10 6 0 −5 0
2
Marginal Revenue
Demand: Q = 6 − P ⇒ Inverse Demand: P = 6 − Q
[Inverse Demand allows us to express revenue as a function of Q only]
0123456
0 1 2 3 4 5 6
PMR
Q
Revenue:
R = PQ = (6 − Q)Q
= 6Q − Q2
Marginal Revenue:
MR ≡dR
dQ= 6 − 2Q
Linear demand curves ⇒ MRcurve is double as steep as de-mand curve!
Marginal Revenue
If a monopolist increases output there are twoeffects:
he can sell the additional produced units of outputonly at a lower price P: P × ∆Q
but he has to sell also all other units of output atthis lower price: Q × ∆P
The resulting change in total revenue istherefore
∆R = Q × ∆P + P × ∆Q
Marginal Revenue is
∆R
∆Q≡ MR = Q ×
∆P
∆Q+ P
Marginal Revenue
In detail:
R1 = P1Q1
R2 = P2Q2 /−∆R ≡ R1 − R2 = P1Q1 − P2Q2
= P1(Q1 − Q2) + P1Q2 − P2Q2
= P1(Q1 − Q2) + Q2(P1 − P2)= P1∆Q + Q2∆P
≈ P∆Q + Q∆P
MR= ∆R∆Q
= P + Q ∆P∆Q
Marginal Revenue
With Calculus:
Market Demand is a function of price:Q = Q(P)We rewrite this and express price as a functionof quantity: P = P(Q).This is called inverse demand function.
Revenue R can then be expressed as a functionof Q only, i.e.
R = P(Q) × Q
For differentiating this use the product rule:
MR ≡dR
dQ=
dP
dQ× Q + P
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Marginal Revenue
Rearranging terms gives
MR = P + Q ×∆P
∆Q
= P + P
(Q
P
) (∆P
∆Q
)
= P
(
1 +Q
P
∆P
∆Q
)
= P
(
1 +1
EQ,P
)
= P
(
1 −1
|EQ,P |
)
Marginal Revenue
Therefore, marginal revenue depends in a veryspecific way on the price elasticity of demand:
MR ≡∆R
∆Q= P
(
1 −1
|EQ,P |
)
When demand is elastic (|EQ,P | > 1) increasingoutput will increase revenue (MR > 0).
When demand is inelastic (|EQ,P| < 1)increasing output will decrease revenue(MR < 0).
Output, Price Elasticity & Revenue
What happens with monopolist’s revenue, when hereduces output?
elastic
inelastic
E = −1
E = −∞
E = 0
P
Q
bc
∆Q
bc
∆P
Elastic Demand:
Q ↓ ⇒ P ↑ ⇒ R ↓
elastic
inelastic
E = −1
E = −∞
E = 0
P
Q
bc
∆Q
bc
∆P
Inelastic Demand:
Q ↓ ⇒ P ↑ ⇒ R ↑
Monopoly
Example
We can see from this simple analysis that amonopolist will never produce a quantity in theinelastic portion of the demand curve. Why?
If demand is inelastic a decrease of quantitywould increase revenue.
Producing less would lower cost.
This implies he could make higher profits byreducing the quantity, therefore this cannot bea maximum!
More generally . . .4
Profit Maximization
Monopolists like all firms maximize profit, andprofit is the difference between revenue andcost π = R − C
For a maximum it must be true that
dπ
dQ=
dR
dQ︸︷︷︸
MR
−dC
dQ︸︷︷︸
MC
!= 0
Therefore profit maximization implies
MR = MC
This result is true for monopolists and for firms on
perfectly competitive markets!
Profit Maximization
Perfect Competition
For a firm on a perfectly competitive marketdemand is perfectly elastic, this implies MR = P.Therefore, profit maximizing firms choose outputwhere
MR = P = MC
Profit Maximization
Monopoly
For a monopolist marginal revenue is
MR = P
(
1 −1
|EQ,P |
)
therefore a monopolist chooses output and price
where
MR = P
(
1 −1
|EQ,P |
)
= MC
MR = MC holds generally, but MR is different for firms underperfect and imperfect competition!
Monopoly: Profit Maximization
P
Q
D(P)
MR
AC
MC
MC MR
⇒
LostProfit
MR MC
⇐
Which quantityshould a monopolistproduce?
When marginal rev-enue is higher thanmarginal cost the firmshould produce more!
When marginal rev-enue is is smaller thanmarginal cost the firmshould produce less!
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Monopoly: Profit Maximization
P
Q
D(P)
MR
AC
MC
MC MR
bc
Q∗M
Which quantityshould a monopolistproduce?
Profits are maximizedwhen the cost of the
last unit are equal the
revenue of the last
unit,
MR = MC
Monopoly: Profit Maximization
P
Q
D(P)
MR
AC
MC
bc
Q∗M
b
bP∗M
b
Monopolies are
‘price-seekers’:
Monopolist choosesthe output whereMR = MC, andcharges the maximumprice consumers arewilling to pay for thisoutput.
Monopoly: Profit Maximization
Profits:P
Q
D(P)
MR
AC
MC
bc
Q∗M
b
bP∗M
b
b
bcπ
Profits are defined as
π = (P − AC)Q
i.e. profits depend
on average cost and
price!
Monopoly: Profit Maximization
Profits:P
Q
D(P)
MR
AC
MC
bc
Q∗M
b
bP∗M
b
b
bc
Loss If AC are high profitsbecome negative, themonopoly runs a loss!
(Still, this output level
minimizes losses.)
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Monopoly
In perfect competition, the market supply curveis determined by marginal cost.
For a monopoly, output is determined bymarginal cost and the shape of the demandcurve (demand elasticity).
Since supply depends on the demand curve,there is no supply curve for monopolistic
market.
Shifts in demand usually cause a change inboth price and quantity.
Example
Monopoly
Profits of a monopolist:
0
1
2
3
4
0 1 2 3 4
P
Q
R
MR
C
MC
bc
bc
Q∗
P∗
bc
bc
bc
π∗
Market demand: P = 4 − Q
Revenue: R = 4Q − Q2
Marginal revenue: MR = 4 − 2Q
Cost: C = 0.2Q2 + 0.5Marginal cost: MC = 0.4Q
Condition for profit maximum:
MR = MC
4 − 2Q = 0.4Q
Q∗ = 1.667
π∗ = R∗ − C∗ = 2.833
Monopoly
Profits of a monopolist:
0
1
2
3
4
0 1 2 3 4
P
Q
R
MR
C
MC
bc
bc
Q∗
P∗
bc
bc
bc
π∗
Q = 4 − P ↔ P = 4 − Q
R = 4Q − Q2, MR = 4 − 2Q
C = 0.2Q2 + 0.5, MC = 0.4Q
Q P R MR C MC π
0.00 4.00 0.00 4.00 0.50 0.00 -0.500.50 3.50 1.75 3.00 0.55 0.20 1.201.00 3.00 3.00 2.00 0.70 0.40 2.301.50 2.50 3.75 1.00 0.95 0.60 2.801.67 2.33 3.89 0.67 1.06 0.67 2.832.00 2.00 4.00 0.00 1.30 0.80 2.702.50 1.50 3.75 -1.00 1.75 1.00 2.003.00 1.00 3.00 -2.00 2.30 1.20 0.703.50 0.50 1.75 -3.00 2.95 1.40 -1.204.00 0.00 0.00 -4.00 3.70 1.60 -3.70
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Monopoly: Alternative Presentation
Profit with Total Cost:
0
1
2
3
4
0 1 2 3 4
P
Q
R
MR
C
MC
bc
bc
Q∗
P∗
bc
bc
bc
π∗
π∗ = R(Q) − C (Q)
Profit with Average Cost:
0
1
2
3
4
0 1 2 3 4
P
Q
MR
MC
bc
bc
Q∗
P∗
ACbc
Attention:
AC(Q∗) = 0.63̇
MC(Q∗) = 0.66̇
π∗
π∗ = (P − AC)Q
Long-Run Profit Maximization
In the long run . . .
Monopolist maximizes profit by choosing toproduce output where MR = LMC, as long asP > LAC
Will exit industry if P < LAC!
Monopolist will adjust plant size to the optimallevel.
Long-Run Profit Maximization
Optimal plant is where the short-run average cost curve is
tangent to the long-run average cost at the profit-maximizing
output level.
A General Rule for Pricing
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Markup Pricing
RememberMR = P
[
1 −1
|EQ,P |
]
= MC
This can be rearranged to express price directlyas a markup over marginal cost MC
P =MC
[
1 − 1|EQ,P |
]
If e.g. |EQ,P | = 2 thenP = MC/(1 − 0.5) = 2 × MC,i.e. the monopolist charges double MC!
Markup Pricing
RememberMR = P
[
1 −1
|EQ,P |
]
= MC
Another way to rewrite this is
P − MC
P=
1
|EQ,P |
The left-hand side, (P −MC)/P, is the markupover marginal cost as a percentage of price.
Therefore, the optimal markup as a percentageof price is simply the inverse of the demandelasticity!
Markup Pricing: Supermarkets &Convenience Stores
Example
Supermarkets:
Many firms, similar products.
The estimated demand elasticity for individualstores is EQ,P ≈ −10
The profit maximizing markup is thereforeP = MC/(1 − 0.1) = MC/0.9 ≈ 1.11MC
Empirical evidence shows that prices are setabout 10 – 11% above MC.
Markup Pricing: Supermarkets &Convenience Stores
Example
Convenience Stores:
Convenience differentiates shops
The estimated demand elasticity for individualstores is EQ,P ≈ −5
The profit maximizing markup is thereforeP = MC/(1 − 0.2) = MC/0.8 ≈ 1.25MC
Prices are set about 25% above MC.
Convenience stores might still have lower profits because oflower sales volume and high AFC! . . .
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Markup Pricing: Rule of Thumb
P
Q
D(P)
MR
AC
MC
bc
Q∗M
b
bP∗M
b
bcπ
Profits
π = (P − AC)Q
are highest whenMR = MC,but managers oftendon’t know theirmarginal cost!
Markup Pricing: Rule of Thumb
P
Q
D(P)
MR
AC
MC
Q∗M
b
bP∗M
b
bc
bc
Therefore, managerssometimes use averagecost AC (or AVC) asa proxy and producewhere AC = MR.
This results in smallerprofits; but the lossmight be small whendemand is rather elas-tic.
Market Power
If demand is very elastic, there is little benefitto being a monopolist; the larger the elasticity,the closer to a perfectly competitive market.
Pure monopoly is rare.
However, also a market with several firms, eachfacing a downward sloping demand curve, willproduce so that price exceeds marginal cost!
Market Power
Firms on markets with imperfect competitionoften produce similar goods that have somedifferences, thereby differentiating themselvesfrom other firms.
This gives them (limited) market power. Theanalysis in this chapter is also applicable inthese cases.
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Market Power
Monopoly power is determined by ability to setprice higher than marginal cost.
For a pure monopoly market power isdetermined by the elasticity of demand the firmis facing.Since the monopoly is the only supplier thedemand it is facing is total market demand.
Degree of monopoly power is determinedcompletely by elasticity of market demand.
Market Power
With more firms in the market offering closesubstitutes elasticity of demand is usually muchhigher, therefore the have much less marketpower.
Demand for a firm’s product is usually (much)more elastic than the market elasticity.Even if market demand for eggs should beinelastic, demand for eggs from a specific farmerXXX is usually very elastic.Attention: For Managers only the elasticity ofdemand for their own product is relevant!
Market Power
Remember:
Monopoly power, however, does not guaranteeprofits.
One firm may have more monopoly power butlower profits due to high average costs.
Profit depends on average cost relative to price!
Measures of Market Power
Lerner Index:
measure of market power that focuses on thedifference between a firm’s product price andmarginal cost of production.
L =P − MC
P=
1
|EQ,P |
Under perfect competition, i.e. when P = MC,L = 0.
When L = 1 the market power is highestpossible.
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Measures of Market Power
Cross Elasticity of Demand:
Percentage change in the quantity demanded ofgood X relative to the percentage change in theprice of good Y:
EQX ,PY=
∂QX
∂PY
PY
QX
The higher the cross price elasticity, the greater thepotential substitution between goods and, therefore,the lower is market power.
Measures of Market Power
Concentration Ratios:
Measure market power by focusing on share ofthe market held by the largest firms.
Assume that the larger the share of the marketheld by few firms, the more market power thosefirms have.Problems:
Describe only one point on the size distribution.Market definitions may be arbitrary.
Sources of Monopoly Power
Why do some firms have considerablemonopoly power, and others have little ornone?
The less elastic the demand for a firm’sproduct, the more monopoly power a firm has.
The monopoly power of a firm falls as thenumber of firms increases; all else equal.
Managers would like to create barriers to
entry to keep new firms out of market.
Barriers to Entry
Economies of scale and mergers.
Barriers created by government.
Input barriers.
Brand loyalties.
Consumer lock-in and switching costs.
Network externalities.
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Barriers to Entry
Economies of Scale and Mergers
Exist when a firm’s long run average cost curveslopes downward or when lower productioncosts are associated with larger scale ofoperation.
Can act as a barrier to entry in differentindustries (→ MES)
Mergers are particularly important in industrieswith economies of scale, e.g. technology,media, and telecommunications.
Minimum Efficient Scale (MES)
MES & Market Entries:
Average cost at half of the MES (1/2 MES) is aindicator for technological market entry barriers.
Highmarketentry
barriers
AC
Q
bcbc
bc
MES
MES
12MES
Lowmarketentry
barriers
AC
Q
bc
MES
bc
MES
12MES
→ important for intensity of competition, Mergers & Acquisitions, . . .
Barriers to Entry: Natural Monopolies
Natural Monopoly: when a firm can supply agood or service to an entire market at a smallercost than could two or more firms.
A natural monopoly arises when there areeconomies of scale over the relevant range ofoutput, i.e., average cost curve is falling overthe relevant range of output.
Natural monopolies cause market failure, andare therefore often regulated or run by thegovernment.
Examples include tap water distributionsystems, bridges, . . .
Barriers to Entry
Barriers Created by the Government
Licenses (e.g. for physicians and otherprofessionals).Patents and copyrights: The need for patentprotection arises because innovations representnew information that has the characteristics ofa public good.
Public goods: A good that has high costs ofexclusion and is nonrival in consumption.Because of free riding behaviour public goodswould not be provided on free markets.
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Barriers to Entry
Input Barriers
Control over raw materials (e.g. diamonds andDeBeers).Barriers in financial capital markets
Larger firms can get lower interest rates.Smaller firms need more collateral for loans.Smaller firms are perceived as riskier.
Barriers to Entry
Creation of Brand Loyalties
The creation of brand loyalties throughadvertising and other marketing efforts is astrategy that managers use to create andmaintain market power.
Managers hope that demand for their productbecomes less elastic by these measures.
Barriers to Entry
Consumer Lock-In and Switching Costs
When consumers become locked into certaintypes or brands and would incur substantialswitching costs if they changed.
Managers often use consumer lock-in andswitching costs strategies to gain market power.Examples for consumer lock-in and switchingcosts strategies:
Contractual commitmentsDurable purchasesBrand-specific trainingSpecialized suppliersSearch costsLoyalty programs, . . .
Barriers to Entry
Network Externalities
Act as a barrier to entry because the value of aproduct depends on number of customers usingthe product.
Can be considered demand-side economies ofscale, in contrast to supply-side economies.
For example software systems.
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Social Costs of MonopolyPower
Social Costs of Monopoly Power
P
Q
Q(P)MR
MC = AC
b
b bP∗C
Q∗C
bc
b
b bP∗M
Q∗M
(For simplicity we assume constant MCand AC.)
Monopoly powerresults in higherprices and lowerquantities.
However, doesmonopoly powermake consumersand producers inthe aggregatebetter or worse off?
We can compareproducer andconsumer surplus.
Perfect Competition & Welfare
P
Q
Qs
Qd
bcValue
tobuyers
Cost toproducers
Value to buyersis greater thancost to sellers!
Cost toproducers
Value tobuyers
Value to buyersis less than
cost to sellers!
Perfect Competition & Welfare
P
Q
Qs
Qd
Consu-mer surplus
Producersurplus
bc
Perfect competition is efficient, becausethe allocation of resources
maximizes totalsurplus!
P∗C
Q∗C
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Monopoy & Welfare
P
Q
MC
D
bcP∗C
Q∗C
bc
MRbcPM
QM
DeadweightLoss
Social Costs of Monopoly
Social cost of monopoly is likely to exceed thedeadweight loss.
The incentive to engage in monopoly practicesis determined by the profit to be gained.Rent Seeking: Firms may spend to gainmonopoly power
LobbyingAdvertisingBuilding excess capacity
Public Policy Toward Monopolies
Government responds to the problem of
monopoly in one of four ways:
Making monopolized industries morecompetitive.
Regulating the behavior of monopolies.
Turning some private monopolies into publicenterprises.
Doing nothing at all (if the market failure isdeemed small compared to the imperfections ofpublic policies).
Antitrust Laws
Antitrust laws are a collection of statutesaimed at curbing monopoly power.Antitrust laws give government various ways topromote competition.
They allow government to prevent mergers.They allow government to break up companies.They prevent companies from performing activitiesthat make markets less competitive.
16
Antitrust Issues
Legislation limits market power of firms andregulates how firms use their market power tocompete.Antitrust legislation focuses for example on . . .
Price discrimination that lessens competition.The use of tie-in sales and exclusive dealings.Mergers between firms that reduce competition.
Antitrust Issues
Focus of the Horizontal Merger Guidelines:
Definition of the relevant market.
Level of seller competition in that market.
Possibility that a merging firm might affectprice and output.
Nature and extent of entry into the market.
Other factors influencing coordination amongsellers.
Extent to which any cost savings andefficiencies could offset increase in marketpower.
Regulation
Government may regulate the prices that themonopoly charges:
The allocation of resources will be efficient ifprice is set to equal marginal cost.However, in natural monopolies this will resultin a loss! (When average cost (AC) fall marginal cost (MC)
must be lower than AC. Optimal pricing P = MC would therefore
result in losses!)
In practice, regulators will allow monopolists tokeep some of the benefits from lower costs inthe form of higher profit, a practice thatrequires some departure from marginal-costpricing.
Public Policy Toward Monopolies
Rather than regulating a natural monopoly
that is run by a private firm, the governmentcan run the monopoly itself (e.g., sometimesthe government runs the Postal Service).
Government can do nothing at all if the marketfailure is deemed small compared to theimperfections of public policies.
17
Any Questions?
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